In May 2015, we reviewed business development companies (BDCs), publicly traded companies that have particularly high dividend yields — some of them higher than 10%. Now that interest rates have (apparently) bottomed out, it’s time to see how they’ve performed, and also to seek out others.

Please see the previous article for a definition of BDCs. In short, they’re regulated investment companies that distribute most of their income as dividends. They generally make loans to small and medium-sized companies, and have been expanding their business in the post-financial-crisis environment, as banks have pulled back from such lending.

And this means BDCs tend to have high dividend yields. In fact, among a list of 50 BDCs prepared by Keefe, Bruyette and Woods, 26 had dividend yields that topped 10% as of Sept. 23, while 41 had yields over 8%.

We are going to share several lists of BDCs that you might consider for dividend income, but first we need to discuss the risks.

Patience is required

The price investors pay to receive the high dividends is volatility. In Keefe, Bruyette and Woods’ list, 49 were publicly traded through 2015, and 42 suffered prices declines for the year.

“In late 2015, the bond market, particularly the high-yield bond market, really started trading down significantly,” said KBW analyst Ryan Lynch, who now covers BDCs for the firm, in an interview. “BDCs are basically portfolios of higher-yielding levered loans and bonds. So if you have a lot of choppiness or a downtrend in high-yield bonds or levered loans, that’s when BDCs will underperform.”

An example of how difficult life can be in an illiquid market was provided by the demise of the Third Avenue Focused Credit, a high-yield bond fund that was forced to close and return investors’ money — or what was left of their money — as the fund sold its assets into a market that didn’t want them.

This two-year chart for the Bloomberg Barclays U.S. Corporate High-Yield Index shows just how much price volatility we’re talking about:

FactSet

So you’ll need to be able to wait out downturns to (hopefully) continue receiving the dividends through thick and thin.

How our first list performed

In the previous BDC article in May 2015, we listed seven BDCs that were rated “outperform” by KBW analyst Troy Ward — who covered the industry for the firm at that time — along with Goldman Sachs BDC, which was relatively new. Here’s how the group has performed since May 13, 2015:

Total return figures reflect the reinvestment of dividends. Then again, since BDCs are income vehicles, you probably wouldn’t be reinvesting the dividends. But you can see the effect of price volatility during a relatively short period for this type of investment. Ideally, you will choose BDCs with excellent underwriting, which means very low credit losses. Leaving aside the share-price fluctuation, you don’t want to see your book value declining very much as you receive the dividend income.

“My opinion is if a BDC pays a 10% dividend, but their book value falls by 5%, I didn’t really get a 10% return. I got a 5% return that year,” Lynch said.

He said that, since credit quality had been unusually solid for several years leading into 2015, credit deterioration over the past year and a half is partially “driven by a normalization of credit,” and partly driven by the decline in energy prices.

Ways to differentiate BDCs

The typical BDC is run by an outside manager that charges 1.5% to 2% a year, based on assets under management, for its services. On top of this, most of the outside managers charge additional fees ranging from 15% to 20% of the income generated.

Some BDCs are internally managed, which can mean that the interests of the managers are better aligned with those of shareholders. “They don’t get paid on assets under management,” Lynch said, “so if an internally managed BDC is growing assets and raising equity capital, you do not have to worry about them expanding just to get paid more.”

Manuel Henriquez, the founder and CEO of Hercules Capital Inc.
HTGC, +0.97%
said that the company, an internally managed BDC, along with its four major competitors don’t charge those extra fees. “We basically charge as if we were a typical corporation, so our salaries are fully transparent and are embedded in our proxy statements,” he said in an interview.

Henriquez called his company “unique,” since it focuses on venture capital. Drug discovery and development, sustainable and renewable technology, software and drug delivery companies account for the biggest holdings, making up 63% of the BDC’s assets.

Here are the five largest internally managed BDCs by market value, according to KBW and FactSet, excluding American Capital Ltd.
US:ACAS
which has a deal in place to be acquired by Ares Capital Corp.
ARCC, -0.12%
:

If you see a major drop in book value, it’s important to find out what it means. Capital Southwest’s 65% decline in book value per share reflects its spin-off of CSW Industrials Inc.
CSWI, +0.57%
in October of last year, with Capital Southwest shareholders receiving one share of the new company for each share they owned.

Here are price-to-book and forward price-to-earnings ratios, as well as consensus price targets and ratings information for this group of internally managed BDCs.

Capital Southwest isn’t covered by any of the sell-side analysts polled by FactSet. There are no “sell” or equivalent ratings for the other four internally managed BDCs on this list. Keep in mind that the expectations for price increases over the next 12 months are just that — they do no reflect the dividends investors expect to receive.

These forward price-to-earnings valuations may appear quite low, when compared with the S&P 500
SPX, +0.69%
which trades at a weighted 16.3 times consensus 2017 EPS estimates, according to FactSet. But S&P doesn’t include BDCs in its indices. Main Street Capital Corp.
MAIN, +0.11%
Hercules Capital Corp.
HTGC, +0.97%
and Triangle Capital Corp.
US:TCAP
are the only BDCs among the 50 listed by KBW that are trading above 1.2 times book value, reflecting investors’ preference for the group.

Among the 50 BDCs listed KBW, 34 have been publicly traded for at least five years. It’s interesting that among the ones with the best five-year total returns, all but Saratoga Investment Corp. are internally managed:

Don’t go it alone

The point of these lists is to highlight some possibilities. The most important thing is that a BDC’s management makes good loans and avoids taking losses. Industry trends, such as the decline in oil prices, can have a major effect on BDC share prices, even when the companies are not overly concentrated in the energy sector. It can take time for prices to recover, but if you are holding well-run BDCs, your income should continue to flow.

Since BDCs do not report credit quality in a uniform fashion, as banks do, it isn’t always easy to understand how much risk is being taken. So you should discuss possible investment choices with your broker or investment adviser. Obtain research reports and read them, along with company filings, and decide whether you think a company’s long-term strategy will work.

Philip
van Doorn

Philip van Doorn covers various investment and industry topics. He has previously worked as a senior analyst at TheStreet.com. He also has experience in community banking and as a credit analyst at the Federal Home Loan Bank of New York.

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